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CFA Level I · CFA Level I Exam · Valuing a Derivative Using a One-Period Binomial Model

In a one-period binomial model for a call option on a stock, the hedge ratio is most likely defined as the:

The hedge ratio is the number of shares of the underlying that offsets the option's change in value between the up and down states, found as the option payoff spread divided by the stock price spread. It makes the combined position riskless over one period.

  1. Anumber of shares needed to offset the option's price change between the two statesCorrect
  2. Boption premium divided by the current stock price
  3. Cprobability-weighted average of the two possible stock prices

Explanation

The hedge ratio equals (option value up − option value down) divided by (stock price up − stock price down). It is the quantity of the underlying that makes the combined position riskless over the period. The other choices are not the hedge ratio: a premium-to-price ratio ignores the payoff spread, and a weighted average price is an expected value.

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